Supervision Of Trading Desk Activities 2006 NSCP National Membership Meeting October 19, 2006 Steven W. Stone Morgan, Lewis & Bockius LLP Susan H. Moore-Wester Hansberger Global Investors, Inc.
www.morganlewis.com
Supervision Of Trading Desk Activities
2006 NSCP National Membership MeetingOctober 19, 2006
Steven W. StoneMorgan, Lewis &
Bockius LLP
Susan H. Moore-WesterHansberger Global
Investors, Inc.
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Supervision Of Trading Desk Activities• Overview of Supervisory Responsibilities• Achieving Best Execution
– Process and Paperwork– Factors in Best Execution
• Three Phases– Pre-Trade– The Execution– Post-Trade
• Selected Best Execution Issues• Measurement & Testing
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Overview of Supervisory Responsibilities
• Responsibilities under the Investment Advisers Act of 1940– Supervision– Reasonable Policies and Procedures
• Standard is one of reasonableness• Delegation principles• Active Response to Red Flags
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Process and Paperwork• Focus on process – “Regular and rigorous” review• Written Best X policy
– Factors for selecting brokers– Criteria to measure these factors– Consideration of alternative markets
• Best X committee– Monitor brokers’ performance– Monitor more than price
• Like market impact and opportunity costs
– Consider evaluation services– Document steps taken
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Factors in Best Execution• Execution capability• Price improvement?• Commission or equivalents• Accessibility and
responsiveness• Need for speed• Value of research provided• Willingness to commit
capital• Assistance in finding
liquidity
• Handling of block trades?• Specialization in markets
or securities manager is trading
• Electronic order access and trade reporting
• Anonymity• Financial responsibility• Low trade errors &
willingness to correct their mistakes
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Three Phases
• Pre-Trade• The Execution• Post-Trade
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Pre-Trade
• Evaluate desk structure– Sector/Style– Fund/Product
• Evaluate trader responsibilities• Evaluate trading desk workflows to
streamline• Broker selection
– Broker Votes– Trading Desk Independence
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The Execution• Aim – Absolute best price given portfolio
manager’s objective– Portfolio manager’s objective is key to how traders
should approach a trade• How assess the prevailing market price?
– Market data– Checking multiple dealers - but how many?
• Trade sequencing issues– Raises tough trading opportunity questions– Myriad trading arrangements complicate order
placement• Trade aggregation and allocation
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Post-Trade
• Broker monitoring– Types of services used– Number of services used
• Broker Evaluation -- Usefulness of “Dash”Reports?– Rule 605 (formerly 11Ac1-3) reports re payment
for orderflow practices– Rule 606 (formerly 11Ac1-6) reports re order
routing practices
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Selected Best Execution Issues• Directed Brokerage Arrangements• Trade Sequencing Issues• Brokers that Refer Business • Trade Aggregation• Trade Allocation• Agency and Agency-Cross Trades• Principal Trades• Cross Trades• Interpositioning• Trade and Handling Errors
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Directed Brokerage Arrangements
• Cross-subsidization issues• Sequencing issues• Due diligence issues• Disclosure issues
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Trade Sequencing Issues• Raises tough trading opportunity questions• Myriad trading arrangements complicate order placement
– Free trading accounts– Directed brokerage accounts– Restricted accounts
• Accounts that say “no” to specific brokers or soft dollars• Wrap accounts• “Preferenced” accounts
• Solutions– Step outs– Rotation– “Back of bus” with disclosure?
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Brokers that Refer Business• Referrals & fund sales
– SEC & NASD Rule Changes Bar direction for fund sales
– Portfolio Advisory Services, LLC (2002)– Duff & Phelps (2001)– Founders Asset Management LLC (2000)– Fleet Investment Advisors Inc. (1999)
• High scrutiny– Disclosure may not suffice!– ERISA issues
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Trade Aggregation• Statutory framework
– 1940 Act Sections 17(d) & 17(j)– Advisers Act Section 206
• SMC Capital no-action letter (1995)– Aggregation of client orders, including mutual funds and proprietary
accounts, allowed uner Section 17(d) if funds participate on terms no less advantageous than others
– Aggregation of client orders does not violate Section 206 if • Adviser discloses aggregation practices in ADV and separately to
existing clients• No advisory account, including a proprietary account, is favored• Each client participates at the average price, with transaction costs
shared pro rata• Pretzel & Stouffer no-action letter (1995) & Q&A• Mass Mutual no-action letter (2000) on Private placements
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Trade Allocation
• Raises more difficult issues than trade aggregation
• SMC’s suggested procedures– Adviser prepares pre-trade allocation report for
each trade– Shares generally are allocated in accordance
with the allocation report• Exceptions where all accounts receive “fair and
equitable treatment” and reason is documented– Adviser keeps records of its allocation practices
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Trade Allocation• Tough issues
– Proprietary accounts & accounts paying performance-based fees
– Do trades always have to be allocated pro rata?
– Does “fair treatment” mean that one client never can be treated more favorably than another?
– Does each client have to pay the same trade costs?
• SEC Enforcement examples– Gerson Asset Mgmt (2005)– Slocum, Gordon & Co.
(2002)– Edward F. Gobora (2002)– Zion Capital (2001)– Monetta Financial (2000)– Nicholas-Appelgate (1998)
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Portfolio Pumping
• Marking the Close to– Enhance performance– Enhance fees
• 2001 OCIE Task Force• Enforcement actions
– Schultz Investment Advisors (2005)– Burton G. Friedlander (2001)– Oechsle International Advisors, L.L.C. (2001)
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Agency and Agency-Cross Trades• 1940 Act Section 17(e) • Advisers Act Section 206(3)
– SEC’s 1998 interpretive release• Rule 206(3)-2
– Client must agree in writing – Affiliated broker must send
client • Trade confirmations• Annual statement showing total
number of agency trades & the total amount of commissions or other remuneration received
– Arrangement must be terminable
– No dual advisory capacity
• ERISA Prohibited Transaction Class Exemption 86-128– Neither adviser nor affiliate can be
a trustee or administrator– Independent fiduciary must agree in
writing– Arrangement must be terminable– Broker must send the fiduciary
• 3 months before the arrangement, information for the fiduciary to evaluate the arrangement
• Annually, a termination form• Trade confirmations• Information, including material
changes to brokerage practices & the portfolio turnover ratio
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Principal Trades
• Principal trades– 1940 Act Section 17(a)– Advisers Act Section 206(3)– Applicability to “riskless” principal trades
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Cross Trades• SEC Focus
– Back Bay Advisors (2002)– Renberg Capital
Management, Inc. (2002)
• Section 206(3) Standard• 1940 Act Rule 17a-7• ERISA prohibited
transaction rules– New ERISA legislation– 2002 exception for Index and
Model-Driven Funds
• Areas of concern– Expectation that client trades
will hit one-another– Continuing focus on
valuation
• Inadvertent crosses– “Blind Pool” Exception
• Delta Government Optionsno-action letter
• ERISA legislative history– Basic requirements
• Orders must be bona fide• No pre-arranged terms• Liquid securities
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Interpositioning• Interpositioning involves an adviser interposing a
broker-dealer between clients and executing broker-dealers – E.g., market makers in OTC principal trades
• Concerns arise where – Done to generate a commission for the broker-dealer in
the middle– Results in the client paying unnecessary brokerage
charges• SEC enforcement
– Portfolio Advisory Services, LLC (2002)– Edgemont Asset Management Corp. and Bowling Green
Securities Inc. (1991)
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Trade and Handling Errors• SEC Examination &
Enforcement focus– Michael T. Jackson and :– EGM Capital (2005)– M&I Investment
Management (1992) – failure to supervise
– Dimitri Balatsos (1992) – fraud & recordkeeping
– Jack Allen Pirrie(1991) – use of “Soft Dollars”
– First Capital Strategist (1997) – failure to supervise, misrepresentation of controls & overstating performance
• What’s a trade error?• Who should pay for errors?• De minimis errors,
opportunity costs & windfalls
• Disclosure issues• Policies and procedures• Dealing with brokers• Error accounts• Performance issues• Insurance
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Measurement & Testing
• Established Services– Plexus– ITG– Abel Noser– Other
• Transaction Cost Analysis• SEC Reports
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Measurement & Testing: Factors in Best Execution Revisited• Execution capability• Price improvement?• Commission or equivalents• Accessibility and
responsiveness• Need for speed• Value of research provided• Willingness to commit
capital• Assistance in finding
liquidity
• Handling of block trades?• Specialization in markets
or securities manager is trading
• Electronic order access and trade reporting
• Anonymity• Financial responsibility• Low trade errors &
willingness to correct their mistakes
www.morganlewis.com
Supervision Of Trading Desk Activities
2006 NSCP National Membership MeetingOctober 19, 2006
Steven W. StoneMorgan, Lewis &
Bockius LLP
Susan H. Moore-WesterHansberger Global
Investors, Inc.